The dichotomy between the strong performance of UK smaller companies investment trusts and their widening discounts means investors should consider holding onto them over the long term, according to Kepler’s Alex Paget (pictured below).
The research analyst explained that, despite the rallying Numis Smaller Companies ex IT index – which is up by 16.23 per cent year-to-date – investors have been deterred from holding exposure to domestic-facing companies amid ongoing Brexit-related uncertainty.
Performance of indices in 2017
Source: FE Analytics
This is shown through the average discount to NAV across the IT UK Smaller Companies sector of 12.3 per cent, which Paget’s research shows is wider than its long-term average. 
In fact, he pointed out that 75 per cent of trusts in the sector are trading on wider discounts than their five-year averages.
“Many smaller companies continue to trade on high P/E [price/earnings] multiples – both compared to large caps and their longer-term averages – despite the potential doom and gloom surrounding the outlook for the UK economy, and so investors could be forgiven for avoiding small caps at this juncture,” he said.
“However, despite the headwinds, we believe smaller companies should continue to offer very attractive returns for those able to handle volatility.”
In the below article, Paget outlines three key pieces of research into UK small caps and why he believes investors should continue to hold them.
Long-term outperformance
One reason that smaller companies trusts are attractive, according to Paget, is that they are highly likely to outperform most other asset classes – including large-cap equities – over the long term.
He referenced research from the JP Morgan research team, which found that UK small and mid caps continue to offer stronger earnings growth and have healthier balance sheets than their larger peers. It also found they are less covered by brokers and are more likely to benefit from M&A activity.
“Their analysis argues that small caps haven’t simply been a higher beta play given they have historically carried lower beta than large caps during short-term corrections – they argue this is because investors tend to sell their most liquid holdings during temporary pullback to avoid higher trading costs,” the research analyst explained. “It’s also because they have posted higher Sharpe ratios [which measure risk-adjusted returns] over the longer term.”
The report also argued that UK small and mid caps are better protected against geopolitical headwinds – such as the need for greater fiscal spending and the rise of populism – given they are more domestic-facing and make up a lower percentage of the equity market capitalisation.
Consistent positive returns
Kepler’s research shows that, over rolling 10-year periods over the past 25 years, the Numis Smaller Companies ex IT index has almost always delivered a positive return and has an average 10-year return of 152 per cent.
In contrast, the FTSE 100 has lost money during six 10-year periods over the last 25 years and has achieved a 10-year average return of 75 per cent.
Rolling 10yr returns of indices over 25yrs
Source: Kepler Partners
“Even on a five-year view, returns from smaller companies have been consistently strong,” Paget said.
“Though smaller companies largely underperformed FTSE 100 in the early 1990s, they outperformed in 75 per cent of the rolling five-year periods we analysed over the 25 years as a whole and only posted a loss in 4 per cent of them.
“The largest potential loss on a five-year view over that time was between April 1998 and April 2003 when the Numis Smaller Companies ex IT index fell 18.17 per cent. Nevertheless, the FTSE 100 fell 30 per cent over that period.”
He added: “The likelihood of smaller companies outperforming large-caps also steadily increases as you extend the rolling return time frames over the past 25 years – further highlighting how important it has been to hold onto small caps during periods of volatility rather than capitulating.”
Income-paying capabilities
Given that past performance is of course no guide to future returns, Paget said an important factor for future performance is how attractive small caps are as a source of income.
“We have already written about the dwindling levels of dividend cover across the FTSE 100 – a problem that few smaller companies have to deal with (dividend cover across the Numis Smaller Companies ex IT index is more than twice as large than across the FTSE 100),” the research analyst continued.
“As such, dividend growth has been far stronger further down the market cap spectrum – the average annualised five-year dividend growth across the AIC UK Smaller Companies sector has been 11.5 per cent per annum against the AIC UK Equity Income sector of 4.1 per cent.”
He pointed out that small-cap trusts have an average yield of 2 per cent compared to the IT UK Equity Income sector’s average yield of 3.6 per cent.
However, he said trusts which invest further down the cap spectrum experience significantly higher levels of dividend growth.
His research – as shown in the below table – shows the average gap between the dividend distributions between the IT UK Smaller Companies and IT UK Equity Income sectors has narrowed significantly over the years.
Average income generation on an initial £10,000 investment over 5yrs
Source: Kepler Partners, FE Analytics
“Given the underlying income generation of trusts such Standard Life UK Smaller Companies, BlackRock Throgmorton, Rights & Issues and Invesco Perpetual UK Smaller Companies (all of which we have covered this month), we would expect this trend to continue,” Paget said.
“As such, we believe there is a clear argument for holding smaller companies over the long-term.”
Bear volatility in mind
Despite the aforementioned positives that UK small-cap investing can offer, the research analyst warned that they will be significantly more volatile than their larger peers at times.
In fact, Kepler’s research shows that the short-term performance of UK small caps is closely linked to the valuation of sterling; as the currency has strengthened in the past, UK small caps have outperformed and, when it has weakened, they have underperformed.
“For the outperformance of small caps to continue over the shorter-term, it appears that the pound needs to either strengthen or at least maintain its value – which doesn’t seem particularly likely given continued Brexit uncertainty,” Paget pointed out.
“In the absence of sterling strength, managers themselves are trying to reduce the risk from further sterling weakness. There is anecdotal evidence that many managers in the AIC UK Smaller Companies Trust sector have been gradually shifting their portfolios towards more internationally-focused companies.
“We also believe that the small cap sector’s stronger dividend growth, and underlying company’s dividend cover puts them at a relative advantage when compared to large caps. Over time – and assuming it continues – this will help provide a buffer to valuations.”
Overall, he said the most valuable way to protect a portfolio is to maintain a long-term time horizon and remain invested in the sector.
“Our analysis shows that if investors bought smaller companies at the worst possible time of the past 25 years – 18 May 2007 – they would have had to wait 43 months to December 2010 before the Numis Smaller Companies ex IT index was back in the black (and 45 months before it was outperforming the FTSE 100),” the research analyst said.
“However, if they had held out for 10 years, they would have witnessed a return of 120 per cent compared a return of 63 per cent from the FTSE 100. So, though they offer long-term rewards, investors do need a great deal of bottle to not capitulate.”
In a future article, we will look at Paget’s four UK small-cap investment trust picks and why he expects them to thrive over the long term.